Chapter 5: Monetary Policy, Fiscal Policy and Aggregate Demand

1. Impact of Changes in Real Money Supply on Planned Expenditures (Section 4-9)

A.     In this section our first task will be to discuss how a change in the real money supply affects real interest rate and real planned expenditures. We begin our analysis by examining the impact of an increase in the real money supply resulting from either an increase in the nominal money supply or a decrease in the price level. 

2. The increase in real money supply will be graphically represented by a shift of LM curve to the right.

1.       The immediate effect is a fall in real interest rate.

2.       The lower real interest rate is known as the liquidity effect of a change in the real money supply on interest rates.

3. Because the fall in the real interest rate increases planned expenditures but real output has not changed so that now planned expenditures exceed real output (or unplanned inventories are negative). 

1.       The depletion of inventories signals businesses to increase output.

2.       The increase in output (and income) increases the demand for money, which in turn increases the real interest rate.

3.        The economy moves up along the LM curve until equilibrium in the goods/services market is obtained.

4.        The increase in the real interest, resulting from the increase in real income, is known as the income effect of a change in the real money supply on interest rates. 

5.       The income effect partially offsets the liquidity effect but the net effect of the increase in real money supply is a fall in real interest rate.

4. The overall impact of the increase in the real money supply is an increase in real expenditure (Y) and a decrease in real interest rates ( r).
1. Deriving the Aggregate Demand Curve (Sections 7-1,7-2,7-3)

A.     Aggregate demand curve is the graphical representation of the schedule showing different combinations of price level and real output at which the money market and the goods/services market are both in equilibrium. The aggregate demand curve (AD) shows the effect of a changing price level on the level of real planned expenditures.

B.     The aggregate demand curve is derived directly from the IS-LM model that we previously developed.  We assume

1.      A given nominal money supply (M)

2.      A given IS curve which in turn depends on consumer confidence, wealth, business confidence, fiscal policy, world income, and exchange rate

3.      A given autonomous demand for money

C.     The aggregate demand curve has a negative slope

1.      An increase in the price level (P) reduces the real money supply, thereby increasing real interest rates that in turn decreases planned expenditures thereby decreasing equilibrium expenditures (Y).

2.      A decrease in the price level (P) increases the real money supply, thereby decreasing real interest rate that in turn increases planned expenditures thereby increasing equilibrium expenditures (Y).

D.     A rightward shift of the aggregate demand curve represents an increase in aggregate demand. It could result from:

1.      Any factor that causes a rightward shift of the IS curve

2.      Increase in nominal money supply

3.      Decrease in autonomous demand for money

E.      A leftward shift of the aggregate demand curve represents a decrease in aggregate demand. It could result from:

1.      Any factor that causes a leftward shift of the IS curve

2.      Decrease in nominal money supply

3.      Increase in autonomous demand for money

F.      A movement along the AD curve graphically represents a change in real money balances that is caused by a change in the price level.  A change in real money balances that is caused by a change in the nominal money supply is graphically represented by a shift in the AD curve.

3. Monetary Policy and Aggregate Demand

A.     Transmission mechanism of monetary policy: process by which monetary policy affects aggregate demand

1.      Interest rate channel: In the Keynesian world there is a very definite transmission mechanism:  Changes in the nominal money supply affect aggregate demand through changes in real interest rates.   First a change in the money supply results in disequilibrium in financial markets; this portfolio disequilibrium causes relative prices and yields of financial assets to change.  In other words, a change in the money supply changes real interest rates.  Second, a change in real interest rates affects planned expenditure (particularly investment and net exports) thereby changing aggregate demand.  Many economists have argued that the Keynesian transmission mechanism is relatively narrow and does not include all the "channels" through which changes in the money supply can affect economic activity.

2.      Wealth channel: Changes in money supply will affect demand, and thus prices, of both financial and nonfinancial assets; as asset prices change so does wealth, which in turn affects consumption expenditure. During the 1990s, the Federal Reserve often discussed a wealth channel with regard to stock prices and housing prices.

B.     Expansionary (easy) monetary policy: Increases in nominal money supply will expand aggregate demand

1.      Reduce real interest rates, which increase investment expenditure and possibly other planned expenditures with resulting increase in equilibrium expenditures

2.      Result in increased prices of assets thereby increasing wealth, which results in higher consumption expenditure

C.     Contractionary (tight) monetary policy:  Decreases in nominal money supply will contract aggregate demand

1.      Increase real interest rate, which decreases investment expenditures and possibly other planned expenditures with resulting decrease in equilibrium expenditures

2.      Decrease asset prices thereby decreasing wealth, which reduces consumption expenditure

D.     Effectiveness of monetary policy in changing aggregate demand (Section 5-2)

1.      One debate that has raged in macroeconomics since the 1930s has concerned the relative effectiveness (size of multiplier) of fiscal and monetary policy in shifting aggregate demand.  This debate was specifically heated during the 1940s, 1950s and 1960s.  Keynesians argued that increases in the nominal money supply were not effective in increasing aggregate demand so the nation had to utilize fiscal policy to increase aggregate demand in order to stimulate the economy.

2.      In technical terms, the Keynesians argued that the monetary policy multiplier was much smaller than the fiscal policy multiplier.

3.      An increase in the interest elasticity of expenditures will increase the magnitude of the monetary policy multiplier; a decrease in the interest elasticity of expenditure will decrease the magnitude of monetary policy multiplier.

4.      Including a wealth channel to the transmission mechanism of monetary policy will increase the magnitude of the monetary policy multiplier.

4.Fiscal Policy and Aggregate Demand

A.      Congress (legislative branch) and President (executive branch) conduct fiscal policy, which involves changing tax rates and changing government expenditures

B.      Expansionary (easy) fiscal policy (increase in aggregate demand) results from

1.       Increase in government expenditures

2.       Decrease in tax rates. If personal income tax rates are reduced people increase consumption expenditures; if business taxes are reduced, businesses increase investment expenditure.

C.      Contractionary (tight) fiscal policy (decrease in aggregate demand) results from

1.       Decrease in government expenditures

2.       Increase in tax rates. If personal income taxes are raised, then consumption expenditures will fall. If business taxes are raised, then business investment will fall.

D.      There are three ways to finance an increase in government expenditures.

1.       Increase taxes (no change in nominal money supply)

2.       Borrow by selling bonds to someone other than central bank (Fed). There will be no change in nominal money supply.

3.       Borrow by selling bonds to central bank (Fed). This method of financing results in an increased nominal money supply. This method is also known as ‘monetization of the deficit” or as “monetary accommodation of fiscal policy”.

E.       Actual budget and structural budget (Section 5-8)

1.       The actual budget has two components: The structural (or natural employment) budget and the cyclical budget.  

2.       The structural budget  (a.k.a. natural employment budget, full employment budget, cyclically adjusted budget or high employment budget) is the budget that would occur if the economy is at natural real output.  The cyclical budget results from the business cycle: It equals the difference between the actual budget and the structural (natural employment) budget.

3.       We can use a diagram to illustrate the relationship between the actual budget and structural budget. The vertical axis represents the budget while the horizontal axis represents real GDP (Y).   The budget line represents net taxes minus government expenditures.  The budget line has a positive slope because an increase in real income results in higher net tax revenue; a decrease in real income results in lower (net) tax revenue.

4.       We note that anything that increases real output will eliminate the cyclical part of the budget. For example, an increase in the nominal money supply will increase aggregate demand.  If the economy is operating at less than natural real GDP, the increase in aggregate demand will increase real output and thereby decrease the actual budget deficit (or increase the actual budget surplus), although it will not affect the structural budget.

5.       Changes in natural real GDP will affect the structural budget. Holding government expenditures and tax rates constant, an increase in natural real GDP will reduce the structural budget deficit or increase the structural budget surplus; a decrease in natural real GDP will increase a structural budget deficit and decrease a structural budget surplus.

F.       Another look at discretionary fiscal policy (Section 5-8)

1.       We have seen that the actual budget deficit changes whenever real output changes.   The second source of change in the government budget comes from alterations in government expenditure (G) and in the tax rate (t).   An increase in government expenditure (or a decrease in tax rates) shifts the budget line downward for any given level of real output because at a given level of output the government spends more (or collects less in taxes) and has a larger budget deficit (or smaller budget surplus). However, the increase in government expenditure or reduction in tax rates may also increase real income - that is, the economy may move along the second budget line so that the actual increase in the budget deficit (or reduction in budget surplus) is less than the increase in government expenditure.

2.       Because actual budget deficits change for several reasons, we measure discretionary fiscal policy by looking at changes in the structural (natural employment) budget caused by either a change in government expenditures or in tax rates, holding natural real GDP constant.  In other words, discretionary fiscal policy involves a shift of the budget line. 

3.       An expansionary (easy) fiscal policy is one that increases aggregate demand; it involves a decrease in tax rates and/or an increase in government expenditure that increases the structural deficit (or decreases the structural budget surplus).

4.       A contractionary (tight) fiscal policy is one that decreases aggregate demand; it     involves an increase in tax rates and/or a decrease in government expenditure that reduces the structural budget deficit or increases the structural budget surplus.

G.      Digression: Tax-Rate Changes and Supply-Side Economics

1.       To this point in the analysis, we have examined how changes in tax rates affect aggregate demand.  Some economists have argued that tax rate changes may have a more significant impact on aggregate supply than on aggregate demand.

2.       Assume that there is a fall in the marginal tax rate on personal income. At the original level of natural real output, the structural budget deficit is larger (or structural budget surplus is smaller).

3.       If the reduced tax rate results in an increase of natural real output, then the impact on the structural budget depends on the magnitude of the increase in natural real output.

4.       Economists generally agree with the "supply-siders" that a reduction in marginal tax rates will increase natural real output.  Economists, however, disagree on the magnitude and speed of this effect; most economists believe that supply-siders overestimate both the magnitude and speed.   In other words, most economists believe that changes in tax rates affect aggregate demand more than aggregate supply in the short run.

5.Crowding Out in a Fixed Price Model (Sections 4-10,5-6)

A.      Crowding out is defined as the decreases in private expenditures that result from an increase in government expenditures thereby reducing the expansionary effects of increasing government expenditures.

B.      An increase in government expenditure will increase the structural budget deficit (or decrease the structural budget surplus). Real interest rates will rise because:

1.       Increased liquidity preference (or demand for money balances):  An increase in real expenditures causes an increase in money demand. 

2.       Alternatively one can argue that the increase in the structural budget deficit results in the government selling more bonds thereby reducing bond prices and increasing real interest rates. We are assuming that central bank is not buying these bonds so there has been no change in the nominal money supply.

C.        The increase in real interest rate reduces planned expenditures that are sensitive to real interest rates so there results less expansion of aggregate demand than if real interest rates remained constant. The presence of the crowding out effect reduces the magnitude of the fiscal policy multiplier.

D.      Magnitude of crowding out effect (Section 5-3)

1.       If the increase in government expenditures is greater than decline in private expenditures, there is partial crowding out.

2.       If increase in government expenditures equals decline in private planned expenditures, there is complete crowding out.

3.       An increase in the interest elasticity of planned expenditures will increase crowding out thereby reducing the magnitude of the fiscal policy multiplier.

4.       A decrease in the interest elasticity of planned expenditure will decrease crowding out thereby increasing the magnitude of the fiscal policy multiplier.

E.       During the 1960s and 1970s, crowding out involved a decline in investment expenditures, particularly in residential housing. During 1980s and 1990s, more crowding out involved decline in net exports (United States had moved to floating exchange rates in 1973).

6. Monetary Accommodation of Fiscal Expansion (Section 5-4)

A.      Monetary accommodation of fiscal expansion, a.k.a. monetization of the deficit, occurs when the Fed's objective (or purpose) is to keep real interest rates constant.

B.       The Fed must increase the nominal money supply to prevent real interest rates from rising

1.       Central bank must increase it purchases of bonds in open market operations.

2.       This increase in the nominal money supply will in effect eliminate the crowding out effect

C.       The increase in the nominal money supply results in a further increase in aggregate demand. Thus, both monetary and fiscal policies are expanding aggregate demand.

7. Countercyclical Monetary Policy Response to Fiscal Expansion (Section 5-4)

A. The opposite response of the Federal Reserve to expansionary fiscal policy is countercyclical monetary policy - a.k.a. "leaning against the wind."   In this case, the Fed's purpose is to try to keep aggregate demand at its original level, most likely because the Fed is concerned that an increase in aggregate demand will result in inflation. 

B. To prevent aggregate demand from increasing, the Fed must decrease the nominal money supply. 

C.      The falling nominal money supply will result in even higher real interest rates. In this case, both monetary and fiscal policies are causing real interest rates to rise.

8. Policy Mixes (Section 5-4)

A.      Both monetary and fiscal policies affect real interest rates and aggregate demand thereby affecting prices/or real output.  Given the wisdom of changing aggregate demand, the question then becomes one of choosing the proper mix of monetary and fiscal policies, which will accomplish the desired change in aggregate demand.

B.      There are in general four policy mixes

1.                             Expansionary (easy) fiscal, expansionary (easy) monetary

2.                             Expansionary (easy) fiscal, contractionary (tight) monetary

3.                             Contractionary (tight) fiscal, expansionary (easy) monetary

4.                             Contractionary (tight) fiscal, contractionary (tight) monetary

C.      There is a great difference between monetary policy and fiscal policy in their effect on the composition of aggregate demand.

1.                             Expansionary monetary policy operates by stimulating interest-responsive components of aggregate demand, particularly investment and net export expenditures.   The most immediate and strongest impact of monetary policy has often been changes in residential construction.

2.                               On the other hand, the effects of expansionary fiscal policy depend on exactly what goods/services the government buys or what taxes and transfer payments it changes.  Each of a great number of fiscal measures (such as road paving, reduction in sales taxes or in corporate profit tax) affects the level of aggregate demand but the beneficiaries of the fiscal measures differ.

D.      Because these policies differ significantly in their impact on different sectors of the economy, problems of political economy develop.  Given a decision of increasing aggregate demand, who should get the primary benefit?  Should the expansion take place through a decline in real interest rates and increased investment expenditure, or should it take place through a cut in personal income taxes and increased private consumption or should it take the form of an increase in the size of the government?  

1.                             Political preferences must settle the above questions.  Political conservatives favor stabilization policies that in a recession cut taxes and in a boom cut government spending.  Over time the government sector becomes smaller.  Growth-minded people and the construction lobby argue for expansionary monetary policies that operates through low real interest rates.  On the other hand, political liberals believe that there is much scope for increasing government expenditure in education, environment, job training and so on; they favor expansionary policies in the form of increased government expenditure.

2.                        A good example of the political debate occurred in 1963-64.   The Democratic Administration wanted to move the economy toward natural real GDP through expansionary fiscal policy.  Certain Democrats, such as John Galbraith, argued that because consumers had enough private goods that there should be an expansion of public goods.  Other Democrats argued that a personal income tax cut was politically feasible and that aggregate demand had to expand to reduce the perceived high levels of unemployment.

E.       During the early 1990s, the preferred policy mix was expansionary monetary policy and contractionary fiscal policy. Both the Budget Act of 1990 and Budget Act of 1993 attempted to increase tax rates and restrain the growth of government expenditures (contractionary fiscal policy). Congress and the President implored the independent central bank (Federal Reserve) to respond with a more expansionary monetary policy. The purpose of the contractionary fiscal/expansionary monetary policy mix was to keep (growth of) aggregate demand relatively constant while reducing the real interest rate. The purpose of reducing the real interest rate was to encourage an increase in business investment.

F.       In summary, policymakers have to choose a policy mix that will change aggregate demand as desired but also makes a contribution to solving some other policy problem. In later discussions we will emphasize two other targets of policy:  economic growth and balance of payments

9. Policy Lags (Section 14-4)

A.      Lags prevent either monetary or fiscal policy from immediately affecting aggregate demand. There are five main types of lags. Some are common to both monetary policy and fiscal policy; others are longer for one policy than for the other policy.

1.                             Data lag: Time it takes policymakers to obtain accurate data about the economy; there is a lag between when changes in economic conditions occur and when economic conditions are measured. This data lag is the same length for both monetary policy and fiscal policy.

2.                             Recognition (interpretation) lag: Time it takes policymakers to interpret data and recognize the need for action. This lag has the same length for both monetary policy and fiscal policy.

3. Legislative (decision) lag: Time between when policymakers recognize that a policy change needs to be made and when policymakers are able to enact a change in policy. The legislative lag is much shorter for monetary policy than for fiscal policy.    FOMC can decide over the telephone to enact a change in monetary policy. Congress and the President often take months to change fiscal policy.

4.Transmission (implementation) lag: Time interval between the policy decision and the subsequent change in policy instruments. The transmission lag is much shorter for monetary policy than for fiscal policy. Once the FOMC has made a decision concerning monetary policy, the open-market manager can buy/sell Treasury securities that immediately will affect short term interest rates, such as the Federal funds rate.

5.       Effectiveness (impact) lag: Length of time for change in policy to have most of its effect on aggregate demand. The effectiveness lag may be longer for monetary policy than for fiscal policy.

B.      Effectiveness lag of monetary policy: the most difficult lag to measure is the effectiveness lag between a change in monetary policy and its impact on aggregate demand. Economists often argue that this lag is long and is variable in length.

1.       Monetary policy can quickly affect short term interest rates

2.       The change in short term interest rates will affect longer term expected real interest rates

3.       Change in long term expected real interest rates will ultimately affect spending/saving decisions on the part of businesses and households

4.       Changes in short term interest rates may affect exchange rates quickly thereby affecting price of exports relative to price of imports; however, it may take some time before this change in relative prices affects volume of exports and imports.

5.       The Gordon text provides empirical evidence on length of effectiveness lag for monetary policy

C.      The total length of lags is long for both monetary and fiscal policies

1.       Monetary policy has a long effectiveness lag

2.       Fiscal policy has a long legislative lag; both transmission and effectiveness lags may also be long

10. National Saving (Section 5-9)

A.      National saving is sum of private saving and public (government) saving

1.       Private saving represents saving of households and business

2.       Public (government) saving is the government budget surplus; a government budget deficit subtracts from national saving

B.      National saving is amount available to finance domestic investment and foreign investment (capital outflows). After 1980, national saving fell as percentage of real GDP

1.       During 1980s and first half of 1990s, large government budget deficits caused the fall in national savings. Foreign savings supplemented national savings to finance these budget deficits.

2.       During the latter half of 1990s, federal government ran a budget surplus but there occurred a drop in private saving so United States still experienced an inflow of foreign savings to finance private investment.

C.      Some economists propose an increase in national savings to finance domestic investment without reliance on foreign savings. Methods to increase national savings include:

1.       Increase private saving rate

2.       Increase government saving rate

11. Aggregate Demand: Summary

A.      In short run, many factors can affect aggregate demand. These factors include monetary policy, fiscal policy, changes in consumer confidence, changes in business confidence, changes in wealth, changes in world income, changes in the nation’s exchange rate, and changes in autonomous demand for money.